GFC puts economic theories to the test

One modest benefit of the extreme — indeed extraordinary — economic times in which we are living is that we get to see the results of a series of dramatic economic experiments in action.

Want to see what happens when you let your financial institutions get too big and too connected to fail and then let one fail anyway? Roll the Lehman Brothers experiment. What about testing the resilience of countries to huge external shocks when they have no exchange rate flexibility and monetary policy is set elsewhere? Roll the Eurozone periphery test. Can partisan politics and boneheaded stupidity help a country lose its AAA status? Cue the US debt ceiling experiment. And so on.

Yet another in this growing line of...shall we say 'interesting'...experiments is the debate over expansionary fiscal austerity. This is sort of the reverse of the Keynesian debate we have occasionally touched on here on The Interpreter, which asks whether regular expansionary fiscal policy can be effective.

The expansionary fiscal austerity argument is the somewhat counterintuitive proposition that tightening fiscal policy (cutting spending, raising taxes) will boost economic growth. There are some (limited) circumstances where this effect might be expected to work, and there has been some empirical evidence of these kinds of non-Keynesian effects working in the past, although under current circumstances (in particular, where interest rates are already very low) I have been sceptical as to the relevance of these argument as applied to, say, the US or the UK.

So, can tightening fiscal policy during weak economic times deliver a pleasant growth surprise? Well, the UK Government has been kind enough to provide us with a test of this proposition, and so far it seems as if austerity UK-style has worked pretty much as the conventional models would have suggested: following a poor first quarter, the UK's second quarter GDP readings have again provided little cheer, and the British economy looks to have more-or-less stagnated since last (northern) autumn. Little sign of any expansionary effects here, then.

Incidentally, the negative message from the UK experiment to date is reinforced by two recent papers which provide a more sceptical look at supposed past examples of expansionary austerity.

Finally, if you would like to find a silver lining from the UK's experiment, this post on The Economist's Free Exchange blog argues that the UK experience, although painful, still compares favourably to that of the economies on the periphery of the Eurozone. As such, it provides evidence of the benefits of retaining an independent monetary policy (and exchange rate flexibility). If you are determined to head off down the austerity route, better to do it with your own currency and central bank.